A Portfolio Superior to S&P500 Regarding Risk and Return

Disclaimer: The following text is a research document made for purely educational purposes, is not and should not be used as an (personalized) investment advice.

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After a recent research on several risk and reward characteristics of some well known dividend paying stocks, we decided to combine those stocks in different portfolios in order to see how they could perform together. The stocks selected and analyzed include Johnson & Johnson (JNJ), Coca Cola Co. (KO), Procter & Gamble Co. (PG), Chevron Corp. (CVX) and PepsiCo, Inc. (PEP). As an addition to those initial ones we also analyzed the same risk and reward characteristics of Apple (AAPL), since our perception is that the company might try to gain its place among the persistent dividend players.
As we will show below adding Apple to the portfolio did not increased so much the risk of the portfolio as the stock’s characteristics alone could have prompted. Adding Apple to the portfolio of dividend paying stocks even made the whole portfolio more appealing regarding the risk adjusted return.

Basics of the Research

For measuring the risk adjusted return of the different portfolios we use the Sharpe ratio. This ratio provides information about whether an investment in a portfolio constituent of the above mentioned stocks would be a better investment than investing in some benchmark index like the S&P500 or the ETF based on it – SPDR S&P500 (SPY) in this case. The higher the Sharpe ratio, the better the investment seems to be.
The Sharpe ratio is derived when the difference between the portfolio return and the return of some risk-free asset is divided by the standard deviation of portfolio returns. In the current economic situation, the yearly return of the 52 week Treasury bill might be considered as being close to zero. Hence, for simplicity reasons we calculate the ratio without subtracting that close to zero return of the risk-free asset.

The Research

The research covers the last 5 years of trading. We started by gathering the monthly returns (adjusted for dividends and share repurchases) of the above mentioned stocks and the S&P 500 index. We then calculated the annualized standard deviation of the returns as well as the annualized historical return. We also calculated some monthly coefficients which can be seen in the following table:

From the table above we could tell that as standalone investments the S&P 500 index (in which a participant could invest by buying the SPY ETF which has an almost perfect positive correlation with the index) and Apple’s stock seem the best choices regarding their risk-adjusted returns. The Sharpe ratios of both options are the highest ones in the group.

Things change when those stocks are combined in a portfolio. The main reason for this is the different correlations those stocks exhibit with each other. A negative or lower correlation has the ability to lower the risk of the portfolio. Hence we combined the five dividend payers in one portfolio with equal weights between the stocks.

The result is shown below:

We see that even that the S&P500 index alone has provided a higher return, it also came at the expense of a higher risk. The difference in Sharpe ratios agrees with that.

We then added S&P500 in the portfolio in order to try to get some advantage of its higher return. In order to not increase too much the number of the different stocks in the portfolio and from risk-adjusted considerations, we decided to drop out two of the stocks – those who showed the lower monthly Sharpe ratios, namely Chevron and Procter & Gamble. The result is shown below:

As expected the addition of the index increases both the return and the volatility. As a good result it also increased the Sharpe ratio which means that that portfolio provided higher return for an unit of risk both compared to the first one and to an investment in the S&P500 index alone.

As a final step we included Apple’s stock in the portfolio. We removed the S&P500 index from it because the correlation between Apple’s stock and S&P500 was the highest in the examined group and we did not want to increase the risk of the portfolio too much. Again the stocks in the portfolio are equally weighted.

The result is shown below:

We could see that the annualized return our new portfolio surpasses the S&P500 index’s one but at a much lower level of risk (7.4% compared to 15.6%). The Sharpe ratio also shows this portfolio as the one from the examined ones that would have minimized the risk and provided the best returns.

As a conclusion we may say that looking at investments as standalone options does not always reveal how they would interact when combined in a portfolio. But at the end of the day (or of the investment horizon) the risk and return of the whole portfolio of the investor matters, not so much the individual positions.